Cross Price Elasticity of Demand

Cross price elasticity of demand is a measure of how the quantity demanded of one product changes in response to a change in the price of another product. It helps determine whether two products are substitutes or complements.

If the cross price elasticity is positive, the two products are substitutes, meaning an increase in the price of one product leads to an increase in the demand for the other product.

If it is negative, the products are complements, meaning an increase in the price of one product leads to a decrease in the demand for the other product.

If the cross price elasticity is close to zero, the products are unrelated or independent.

Cross price elasticity = % change in demand for X / % change in the price of Y

Example of Substitute Products:

Let's consider two brands of smartphones, Apple and Samsung. Suppose the price of Apple smartphones increases from $1,000 to $1,200, and as a result, the quantity demanded of Samsung smartphones increases from 1,000 units to 1,200 units.

Cross Price Elasticity = +1

Since the cross price elasticity is positive (1), it indicates that Apple and Samsung smartphones are substitutes. An increase in the price of Apple smartphones leads to an increase in the demand for Samsung smartphones.

Example of Complementary Products:

Consider the case of coffee and cream. Suppose the price of coffee increases from $5 to $6 per pound, and as a result, the quantity demanded of cream decreases from 500 cartons to 400 cartons.

Cross Price Elasticity = ((400 - 500) / ((500 + 400) / 2)) / ((6 - 5) / ((5 + 6) / 2)) Cross Price Elasticity = (-100 / 450) / (1 / 5.5) Cross Price Elasticity = -0.44

Since the cross price elasticity is negative (-0.44), it suggests that coffee and cream are complements. An increase in the price of coffee leads to a decrease in the demand for cream.